The pricing/mispricing of securities does not simply reflect numbers (earnings, volatility, risks, prospects, economic and financial trajectories, etc.) but rather tell a story. Sometimes this story is about the promises of a brilliant future (“the sector has entered into a new regime”, “the growth prospects will revolutionize the sector”), or the dangers of a forthcoming storm (“the debt levels will ruin the economy”, “the fundamentals cannot justify the current prices”). The reality is that the story reflects the hunger we have for patterns and for meaning. However, the reality also is that the day will come when the facts will no longer care for the narrative. That’s when the mean reversion not only knocks at the markets’ door but violently tears down the walls. Mean reversion is just reality reasserting itself.
In our last commentary we briefly touched on Albert Camus’s rats in the city of Oran – which chose to ignore the signs – that became the epicenter of a plague that devastated the city. My favorite Camus story is the story of Sisyphus (originally found in Platonic traditions). Sisyphus was the founder and king of what is today, Corinth. Sisyphus revealed Zeus’s secret and cheated death, so he was condemned to push an immense rock up a hill, only for it to roll back down as it neared the top. The Sisyphean story is not a tragic story. On the contrary: it represents the triumph of realism and discipline. Knowing full well that the rock will roll back, the disciplined individual prepares for the reversion and is strong enough to push up the rock again!
The story seems to be the same: Mispricing happens as we narrate ourselves into a false permanence to avoid an absurd reality. Camus’ revolt (seen from a market perspective) is not about predicting when the markets will reverse or pretending that we can avoid the reversion. Camus’s revolt as applied in market strategy is about a disciplined approach that targets the historical market average return while allowing a reasonable upside or downside while embracing reasonable risks.
In his latest book titled The Making of a Permabear, the legendary investor Jeremy Grantham discusses that the historical average return in the market is 6%, and how investors lose sight of facts by relying on easy credit and the reinforcement of misplaced beliefs that encourage leverage and animal spirits, all of which lead to low-risk premium that is a clear sign of bubble creation. Moreover, low volatility when properly seen using contrarian lenses should be interpreted as a leading indicator that current optimistic conditions will regress to the normal rather than extrapolating them into the future.
The current market makeup lives in a tension between an upswing based on unsustainable threads and the historical fact of mean reversion. The former is supported by government deficits and debts, capital spending on AI, and spending by the retiring baby boomer generation that has accumulated wealth and savings. The AI overspending by hyperscalers to the tune of $2.5 trillion represents a fraction of AI revenues, and such monetization seems to be indifferent to cash flows, depreciation schedules, AI adoption, let alone a realistic model of actualizing profits rather than burning cash.
The story sounds good and songs of celebration might be sung at the top of the hill, however the reality is that the rock will roll back. “This time is different” is not openly pronounced, however the circular deals among the major AI players portray that attitude, especially after incidents of mean reversion surface in the markets (like in the beginning of the summer). Despite institutional warnings ranging from the IMF, The Bank of International Settlements, and the Bank of England, the market is oscillating between overextension and correction.
The geopolitical realities, on the other hand, from the Middle East (Iran, Israel, Syria, Turkey, Yemen, UAE, and Saudi Arabia) elevate the inflation uncertainty, while the Russian atrocities and ambitions to destabilize Europe find fertile ground in a continent where the middle class has been betrayed and seeks alternatives to populists who can only make instability worse. Furthermore, China’s own ambitions (to be seen as a global stabilizing power which floods the markets with its own products and currency) is an effort to defy its own steroid/debt reality before gravity reasserts itself elsewhere. The fact is that there is a wave of autocratisation which is not confined in fragile states, where institutions erode, and such erosion is rationalized away.
When all the above are seen using the most absurd story of the ever-expanding debt, we can realize that a genuine fiscal reckoning could be so costly that everyone will try to do whatever it takes to prolong it a bit more. When that mean reversion starts knocking at the door, its impact and correction could potentially be generational rather than being felt in a single or two bad years.
The threads of unsustainable debts, unsustainable AI spending along with security threats, rising geopolitical tensions, and eroding institutional order are becoming a mechanism of institutionalized instability where even if something relatively small breaks, or the AI trade reverts (undeniably the latter being a genuine growth engine), mean reversion could have a generational impact.
Last week Peter Orszag (chairman of Lazard Investment Bank) in a speech at the London School of Economics reminded us all of the Challenger disaster 40 years ago, when a very weak link brought in a historic disaster. As I was reading the speech, Sisyphus’s echo was coming through: “I know it will roll back down…”
